An Experiment With Shorting The Market

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The WSJ featured an interesting story with the intriguing title “An Experiment Shows The Risk Of Shorting.” Let’s listen in:

Back in late October, with stocks rallying, I decided to hedge some of my exposure by buying a “short” exchange-traded fund—an ETF designed to rise when the market falls. At the time, based on historical norms, the market was overdue for a correction.

After all, stocks had gone up nearly 57% without any correction of 10% or more since March, despite a sluggish recovery and rising unemployment. So I bought shares in the ProShares UltraShort S&P; 500 fund, which aims to double the inverse return of the Standard & Poor’s 500-stock index. In other words, for any given day, if the S&P; 500 fell 10%, this ETF would be expected to gain 20%. I wrote then, “I’m deliberately calling this an experiment, not a recommendation. I suggest that conservative investors let me be the guinea pig.”

The guinea pig is back with his report.

It’s long been my policy to avoid bets on short-term moves in the stock market. There are good reasons for this. No one else has been able to predict the market’s short-term direction with any consistency, so why should I? I only expected to hold the short ETF until a correction materialized, then sell.

And indeed, despite my expectations for a correction, none came. On Oct. 27 the S&P; 500 was at 1063; by Christmas it was 1126, a gain of 63, or 6%. My ETF, as expected, went the other way and lost more than twice that much, or 13%. So, as I reported on Dec. 23, I figured the market was even more ripe for a correction. I bought the ProShares UltraShort QQQ fund, which aims to achieve twice the inverse return of the Nasdaq 100 for a single day. At that point, the Nasdaq Composite was at 2253. Still, the market kept rising; the Nasdaq hit 2320 on Jan. 19.

Then I was vindicated—somewhat. By Feb. 5, the Nasdaq Composite had dropped as low as 2100 intraday, or just under 7% below its level when I bought the short ETF. The Nasdaq 100 had fallen similarly. I was looking at a gain of over 8% in my UltraShort QQQ shares. Coincidentally, the S&P; 500 fell to 1063 the previous day, right where it had been when I bought the UltraShort S&P; 500.

But then what? I hadn’t developed a clear-cut exit strategy. I had the idea I’d sell the short funds when the Nasdaq Composite had dropped 10%, a standard correction. But it never quite hit that threshold. Still, I no longer had the sense that stocks were so overvalued. Much had changed since October. Corporate earnings were rolling in, and they were strong. Multiple indicators suggested the economy was indeed improving. Despite the decline, the market seemed remarkably resilient considering all the bad news, such as worries about Greece defaulting. And then, the markets resumed their climb. Last week the S&P; 500 was back to 1076 and the Nasdaq to 2184.

I bailed out, a modest gain in my UltraShort QQQ shares offsetting a small loss in the UltraShort S&P; 500. With transaction costs, I pretty much came out where I would have been had I held cash.

The short ETFs performed as advertised, but I doubt I’ll be buying them again anytime soon. It may turn out I sold them prematurely, and that the long-awaited correction of more than 10% is just around the corner. But who knows?

The problem with selling short—which is really just the problem of selling, magnified—is you have to be right twice. You have to know when the market is overvalued, and then you have to know when a correction has run its course. I know there are many successful short sellers, but I don’t like those odds.

It’s obvious that the idea was to simply experiment with no clearly defined entry and exit points, so for that I appreciate the author being the guinea pig.

However, it brings up an interesting question, which has been asked by readers many times. How about selling short when the domestic TTI (Trend Tracking Index) crosses its long-term trend line to the downside and into bear market territory?

If you are an aggressive investor, you can allocate a portion of your portfolio to this approach. I found that there is a world of difference in looking at a chart with the benefit of hindsight and acknowledging that this point would have been a good one to short and actually implementing such a discipline.

What the chart does not tell you is the incredible volatility that you may have to face when taking a short position in bear market territory. Several readers shared their experiences with me back in 2008 when the bear struck and they went short. Violent market swings in both directions made that an endeavor for only the gutsiest of investors.

Nevertheless, I liked the author’s willingness to share the good with the bad, and it gave me the idea to do the same. My plan is that, once the domestic TTI breaks below its long term trend line and moves into bear market territory, I will take a position in SH (only for my personal account) and share my experiences with you.

To me, it’s not a question if we get to the bear market territory but only when.

Vanishing Fears

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It’s not that the Greek debt crises disappeared over the Holiday weekend, but soothing words and lack of front page news were enough to alleviate or at least postpone fears of an imminent crisis. For the past 1-1/2 weeks, the market was headline driven and kicked around depending on the news from Europe.

No news was good news yesterday, and the major indexes, supported by a better-than-expected manufacturing index, along with a weaker dollar and a rally in commodities, did not hesitate and off to races we went.

While the rally was indeed impressive, we have to wait and see if this was a one-day wonder, or if short-term momentum has actually reversed. Major resistance for the S&P; 500 lurks around the 1,100 level, give or take a few points.

Mish at Global Economic Trends featured an interesting piece this morning, which resonated with me. It’s a lengthy article, but here is the summary titled “Something Is Brewing:”

Pressures mount as China attempts to walk a fine line between overheating and an economic bust accompanied by massive social unrest.

Elsewhere, central bankers assume the global economy is in recovery. In reality, the global economy is in another speculative binge fueled by reckless global stimulus, with China at the head of the pack.

Meanwhile, global imbalances grow with most eyes on Greece and Spain. Let’s not forget the massive property bubbles in Australia and Canada, and massive speculation in China. In the US, cities and states are on the verge of bankruptcy.

Something is brewing alright. That something is “trouble”, and not just for China.

That’s been my feeling for some time, which is why I don’t mind having a reduced exposure to the market due to some sell stops having been triggered last week. Once I can indentify that the major trend has in fact resumed, I will reconsider and add to my current positions.

Online Broker Commission Cuts Continue

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The NYT featured an interesting article titled “What To Look For In An Online Broker,” which features a comparison of the major players in the business:

Charles Schwab fired the first shot when it cut its trading commissions last month, and now Fidelity and E*Trade have followed with price cuts of their own.

All of the changes may have made you think about switching brokers. Or, maybe you’re wondering if this should be a factor as you shop for a new brokerage account.

First, a quick review: Schwab cut its trading commissions to a flat fee of $8.95 in January. A few weeks later, Fidelity lowered its trading fees to $7.95. And last Friday, E*Trade said it would drop its fee to $9.99 or less per trade. None of them has cut prices below the $7 per trade charged by Scottrade, which remains the cheapest among the largest online brokers.
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Why now? One reason the brokers cut commissions was to simplify their pricing and charge flat fees. Before the changes, Schwab, Fidelity and E*Trade all charged additional fees (about 1.5 cents per share) on top of their base commissions for people who traded more than, say, 1,000 or 2,000 shares, said Matt Snowling, an analyst who covers the online brokerage industry at FBR Capital Markets.

And as stock prices plummeted in late 2008 and early 2009, the size of the average trade in many widely held stocks increased. So it wasn’t unusual for investors to trade thousands of shares (think Citigroup at $3) — and that could add another $50 or so on top of the base commission. “The fact that none of the moves set a new price point below Scottrade is telling that we are not entering a true price war,” he added.
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All of this is good news for the average investor. Lower trading commissions are always welcome, though these changes won’t really affect you if you don’t trade that often — and most long-term investors don’t (nor should they).
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When you’re shopping for a broker, you need to consider the tools, services and funds they offer — that’s what really differentiates providers these days. For instance, while most brokers offer hundreds if not thousands of mutual funds, many will charge a “transaction fee” that can run up to $50 or more to invest in funds that aren’t on their “preferred” lists. So when you’re shopping around, make sure you won’t have to pay one of these fees to invest in your favorite funds. If you’re a fan of Vanguard index funds, for instance, you probably don’t want to invest in them through Schwab, which charges nearly$50 every time you make a deposit.

A 2009 study by J.D. Power and Associates asked more than 5,000 self-directed investors about their satisfaction with the major online brokerage players, and they ranked Charles Schwab at the top of the list. Vanguard came in second, followed by Scotttrade. Schwab’s customers were happy with its tools, account information, educational offerings, and interactions with its Web site. Vanguard, meanwhile, got high grades for its account offerings and phone-based interactions. And Scottrade received good marks for its trading charges and fees, as well as interactions through its branch offices.
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The study also found that investors who used the tools and resources offered by their brokers were more satisfied than those who did not. That shows that price isn’t always the most important factor. Nor should it be.

If you are in the hunt of finding/evaluating a new online broker, I suggest you read the above link in its entirety.

Price wise there is not much difference so tools and resources may come into play for some. For example, if you are following the trend tracking method of investing, take a look and see if someone offers a simple but effective way to track your sell stops.

Or, if your work schedule has you on the road quite a bit, inquire about the possibility of using your cell phone as a trading tool, should you have the need to enter sell stop orders.

I agree that the decision of which broker you select should not be all about price, but mainly how you work and invest and who gives you the tools to best implement your investment strategy.

Is It Time To Sell Bond Funds?

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One reader has a portion of his portfolio invested in bond funds and is wondering if they still make sense. This is what he had to say:

Do you have any insights and advise for people who are currently holding bonds such as MWHYX and PTTDX in their portfolios? While both of these funds have performed phenomenally over the past decade is now the time to consider dumping them?

In the past I have always been a big believer in having a bond component in my portfolio, and it has served me well.

With interest rates set to rise, and a “bond bubble” having formed should investors dump these bond funds from their portfolios?

First, eventually the “bond bubble” will bring down the stock market, unless it is pulled off its current level by another trigger.

Second, we don’t have higher interest rates yet; they are merely a known factor lurking on the horizon with no specific time frame. The Fed announced last week that “accommodating” interest rates are here to stay for the time being—whatever that means.

To me, the solution, as to whether you should sell your bond funds or not, is very simple. Follow the trend! Apply the customary sell stop strategy to bond funds just as you would to equity funds.

Take a look at the above chart in which I am comparing the funds you own with the S&P; 500. It’s obvious that your junk bond fund (MWHYX) tracks the S&P; 500 though with somewhat less volatility. The more diversified PTTDX has shown more stability during the downturn of 2008 and into 2009.

As a result, I suggest you use a 7% trailing stop loss for MWHYX and a lesser number, maybe 5% or so, for PTTDX. That way you don’t have to guess if now is a good time to sell or not. You simply let the market tell you when it’s time to exit.

Disclosure: I don’t have any positions in the funds discussed above.

Sunday Musings: It’s All About Personal Choice

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Some new readers of this blog are not up to speed as to what trend tracking is all about and still have a buy-and-hold mentality. Here’s one comment I recently received:

While a 7% sell stop strategy may prevent major losses during a Market melt down, they also greatly inhibit the upside over the long run.

John Bogle, and many other highly respected investors point out the folly of trying to time the Market. There have been innumerable studies that show that moving in and out of ETF’s and Mutual funds over the long run can cost an Investor as much as 25% on return.

While I do admit that being stopped out might prevent a major portfolio loss, it also locks in many 7% losses while at the same time incurring Tax and trading expenses.

Here’s the thousand dollar question! Once your stopped out, when do you decide to buy back in? And when you do buy back in is there any guarantee the Market won’t stop you out again for another 7% loss? Of course this loss will be on newly invested money that probably missed out most of the rally after the first stop out.

Since all of these issues have been addressed before, I will just comment in general. Most studies in support of buy and hold (b&h;) have been done by the staunchest supporters of that investment approach, which makes the results biased.

Dalbar and Morningstar come to mind. I’ve seen some of the results in the past, and it seemed to me that they attempted to cherry pick those periods that supported their point of view, because bear markets were never included as if they did not exist.

You have to realize that the reason b&h; gets so much support is that that’s where the compensation for many comes from. Wall Street’s army of commissioned brokers needs to have a way to generate revenue no matter what the market is doing. If you’re not invested and in cash on the sidelines (for good reasons), no commissions can be generated.

The meltdown of 2008 has supported my long-held view that it is more important to control downside risk than to participate in every up tick of the market. Case in point is the sharp rebound of 2009, over which most brokers have gone wild, yet the S&P; 500 still needs to rise 22.55% (as of Friday) to reach the level our Trend Tracking Indexes signaled a sell on June 23, 2008.

With the markets starting to crack, this will be a tough one to make up, and could very well take many years.

There always seems to be a battle brewing, and investors, just like sports fans, have the urgent need to see a winner, no matter what. Back in the late 80s and 90s, it was load mutual funds vs. no load funds. Over the past few years, it was ETFs vs. no load funds and, of course, there is always at good time to pit trend tracking vs. b&h.;

Personally, I think it’s the wrong attitude. This is not about one being superior to the other; it should have to do with personal choice only, and my preference is the use of trend tracking.

I have received the phone calls back in 2001 when investors lost a big chunk of their portfolios and again in 2008 when disaster struck. I’ve heard the sad stories as a result of having held assets through a bear market that ended up changing lives forever.

Despite my bias, it is not a matter of right or wrong. If you can accept the fact that every so often a bear market wipes out some 50% of your portfolio, then you should stick with b&h.; If you can’t handle that, then you should consider trend tracking. It’s all about having a choice about what fits your emotional make up better and not a matter of right or wrong.

To be clear, no one investment approach is perfect. We live with the imperfections of trend tracking by getting whipsawed occasionally and try to keep investment losses manageable so that they can be made up quickly.

On a fundamental basis, I need to point out that years (or decades) of financial mismanagement have come to an end with the burst real estate/credit bubble, not just here in the U.S. but worldwide.

As a result, there is a gigantic debt overhang and inability to pay along with reduced revenues on all levels ranging from Federal, State and municipalities the outcome which has not been absorbed yet by the current economic rebound.

My view is that economic and global uncertainly is here to stay and with it the ever present danger that a bear market can strike again. As I have repeatedly posted, the alleged economic recovery was built on nothing but hype, hope and government stimulus.

I for one prefer not living in an investment dreamland where I can simply buy and hold a mutual fund or ETF without worry. Once reality sets in again, I will be glad that there is an investment option that will keep my portfolio from getting a serious haircut.

That’s my choice—you have to make yours.

Above The Sell Stop

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One reader was looking for some clarifications as the Trend Tracking Indexes (TTIs) have retreated sharply with recent market activity. This is what he had to say:

You mentioned some of your sell stops were hit. I have to believe all were hit since hardly anything has withstood a 7% loss, this Tuesday’s rebound notwithstanding.

So given that the TTI is still above the trend line, are we to deploy into those funds that are higher on the charts? Or, are to chill until they take out their highs before jumping in?

Also you mention “we are closer to bear market territory”. Are you talking about “sell everything” situation – assuming there are still some positions we haven’t been stopped out of – or are you talking about actually shorting the market?

As is no surprise, the most volatile funds and ETFs are the first ones to trigger their sell stops as the market corrects. However, not all 7% trailing stops have been triggered, since we owned some conservative holdings that have so far stayed above the sell stop level. I talked about that in more detail in “Using The Benefit of Hindsight.”

If you have been stopped out, be patient as it is not clear yet that the uptrend has resumed. Please review my thoughts on reinvesting as described in “Deploying Stopped Out Money.”

Yes, we have clearly moved closer to bear market territory. What that means is that the TTIs have moved within striking distance of piercing their long term trend lines to the downside.

If that occurs, we will have left the bullish zone. At that moment, you should have no positions at all. As I have posted before, the international TTI has raced ahead of the domestic TTI with the result that we no longer hold any international positions.

Once any of the TTIs cross into bear territory, you can, if you are an aggressive investor, short the overall market by selecting the appropriate ETF. Will I do so? No, most of my clients are too conservative, so I will stay on the sidelines watching the debacle unfold. There may be a long opportunity in certain sectors, but it is too early to tell, which ones they may be.

However, I believe that once this market heads south, we will see a dollar rally, so I have my eyes feasted on UUP, although right now I don’t have any positions in it.